Congress Reaches Debt Ceiling Deal

August 01, 2011

GW economics professor analyzes the agreement and the broader U.S. debt problem.

Republicans and Democrats worked all weekend to reach a deal on the nation’s debt ceiling. Late Sunday, a compromise was reached that will raise the debt limit in two stages – the first by $900 billion and the second as much as $1.5 trillion. A new joint legislative committee would be required to come up with domestic and defense spending cuts that would match the increase to the debt ceiling. Congress is expected to vote on the deal later today.

Tara Sinclair, an assistant professor of economics and international affairs in the Elliott School of International Affairs and the Columbian College of Arts and Sciences, talks to GW Today about the latest deal reached between party leaders to raise the debt limit and what it means for the nation moving forward.

Q: What are the key points of the latest agreement reached by Republicans and Democrats?

The agreement is to raise the debt ceiling—and make corresponding cuts to spending—by up to $2.4 trillion in two stages. The first stage raises the debt ceiling by $900 billion and cuts the budget by about the same amount over the next 10 years, building on the cuts proposed in past discussions. The second stage depends on following the recommendations of a committee that will be formed to try to find another $1.5 trillion in cuts. The total increase in the debt ceiling should be enough to keep borrowing into 2013.

Q: Why is America’s credit rating still uncertain?

Credit agencies are not only concerned about the immediate risk of the government potentially defaulting on its financial obligations without an agreement to raise the debt ceiling, but they are also concerned about the longer-term commitment of the government to honor its financial obligations. Raising the debt ceiling in the nick of time this time suggests that the government may not be able to reach an agreement next time. On the other hand, there is also the concern about the size of the U.S. debt as well as the projected increases due to the increasing costs of Medicare and Social Security. At some point the U.S. government may not be able to repay its debts. The risk of that potentially happening may result in a credit downgrade if the ratings agencies don’t think the deficit-reduction plans put forward by Congress go far enough.

Q: What was left out of the agreement that Democrats would have liked to see? Republicans?

Democrats would have liked some revenue increases and a smaller amount of spending cuts. Republicans have said they would have liked more cuts sooner in the 10-year window. Furthermore, many in the Tea Party wing of the Republican Party are against any increase in the limit. They want to immediately balance the budget by cutting spending dramatically

Q: Why is the debt ceiling so important?

The debt ceiling comes from a federal law that was first passed in 1917. It was originally designed to help the U.S. borrow money for World War I by making it easier for the U.S. Department of Treasury to sell bonds. Before 1917 Congress had to approve every bond sale. Now it allows the Treasury to handle the bond sales and only revisit the issue when the most recent cap Congress has set on total outstanding debt is reached. Congress regularly has to vote to raise the U.S. debt ceiling, and it has become a time to recognize the impact of budget deficits, which add to the national debt.

If Congress does not increase the debt ceiling then the Treasury will be unable to borrow funds beyond the cap, which is currently set at $14.29 trillion. Earlier this year Congress approved a budget that included a substantial deficit. This means that they have committed to spend more than they expect to receive in revenues. Therefore, the Treasury needs to borrow funds by selling bonds. The amount they need to borrow is considerably more than the remaining room before hitting the debt ceiling. This means that in order to follow the budget, the debt ceiling has to be raised. Otherwise, the government will have to break important commitments.

Raising the debt ceiling does not mean increasing spending. Congress authorizes spending through the annual budget. At this point we need to raise the debt ceiling just to find the funds approved in this year’s budget. Even if the debt ceiling is raised substantially, government spending is determined by the budget, not by the amount of borrowing left below the latest debt ceiling.

Q: How many times has the U.S. raised its debt limit?

According to the U.S. Treasury, since 1960, Congress has acted 78 separate times to permanently raise, temporarily extend or revise the definition of the debt limit – 49 times under Republican presidents and 29 times under Democratic presidents. The need to raise the debt ceiling has regularly come with substantial political wrangling, so arguing over the debt ceiling is nothing new, but it does appear to have been particularly serious this time around.

Q: What happens when the U.S. reaches the debt cap?

If the U.S. reaches the debt cap and Congress does not approve further borrowing then the government will not be able to fulfill all of its obligations as agreed to in the most recent budget. Some law will be broken – either the debt ceiling will be breached or the budget will not be honored. According to the Treasury, to avoid exceeding the debt ceiling, it would need to cut or delay payments for things like Social Security, Medicare, government and military salaries and many others.

In a worst-case scenario the government may not even be able to pay the interest on the national debt. This would lead to a full-fledged default on our debt. In this case the U.S. would no longer be considered trustworthy to fulfill its financial obligations. This would make future borrowing, even just to roll over existing debt as bonds mature, much more expensive. The Treasury would therefore have to pay higher interest rates to entice people to buy the bonds that would now be considered much more risky. In fact, even just not paying other obligations while still paying interest on the debt will probably nevertheless affect the perceived creditworthiness of the U.S. and push interest rates up substantially.

Q: How did the U.S. government get into this problem?

Every time Congress passes a budget in which spending will exceed revenues (i.e., a deficit) it is deciding to increase borrowing and therefore add to the government debt. Budgets over the past several years have included substantial deficits, in large part because of the recent recession – tax revenues were lower than usual due to lower employment and reduced economic activity and spending was up both from the stimulus package and because of increased demands on government programs like unemployment insurance.

Q: How soon would have the U.S. government been unable to meet its financial commitments?

The Treasury said that it expected to only be able to cover spending until Aug. 2. In fact, it already reached the debt limit back in May and has been using what it calls “extraordinary measures” to extend the deadline to August. These measures include delaying payments into the federal employees’ retirement fund. The payments to current federal retirees continue unaltered but the saving for future retirees has been put on hold. By law when the debt ceiling is raised these payments will be made to ensure the government will meet future retirement fund obligations.

Q: What kind of impact would a default have?

A default of any sort would be disastrous for both the U.S. and the rest of the world. The first impact would be that interest rates would rise substantially. Higher interest rates would make it more expensive for everyone to borrow. Business loans would be more costly so firms would cut projects and jobs, mortgages would be more expensive at a time when the housing market is still weak, personal loans and credit cards would be more difficult to get exactly when households might need them most to weather the economic difficulties.

Because the rest of the world relies on the U.S. to be a safe place to put money, a default would likely also bring about another global financial crisis. The Treasury claims that a default would “precipitate a self-inflicted financial crisis potentially more severe than the one from which we are now recovering.”

Q: How would a default affect the average American?

Average Americans would see their interest rates go up on mortgages, car loans, student loans, credit cards, etc. Many people would also likely lose their jobs as firms would find it more expensive to borrow. Taxes would likely also have to rise because the government would be paying substantially higher interest rates on existing debt.

Q: What were the major points of disagreement between the Republicans and Democrats?

The parties disagree on the best way to reduce the growth of government debt. The Republicans have emphasized reducing spending, whereas the Democrats also want to find a way to increase revenue. The economic evidence is mixed as to what works best. There is also a question of when the government should focus on debt reduction. Some economists argue that the economy is still weak right now so it might not be the right time to reduce government spending or raise taxes. The U.S. government, however, cannot continue to grow the debt at the rate it is currently forecast to grow. This means that a reduction in spending, an increase in revenues or some combination will be necessary in the near future.

One of the major points of contention became the size of the increase in the debt ceiling. The Democrats argued for a larger increase so that there is enough room to not have to go through this again in 2012. In that case there wouldn’t be another debt ceiling vote before the next election. It would also provide more certainty for the markets since it would be clear that the government is committed to meet its obligations for a longer period of time. The Republicans want to have a smaller debt ceiling increase to revisit the issue sooner. This would allow more time to come up with a better and more complete plan for long-term debt stabilization and perhaps even reduction.

Q: Has the U.S. ever defaulted on its loans?

No, the U.S. Treasury bond is considered the safest asset in the world to hold precisely because the U.S. government has never defaulted on its legal obligations.